After the loonie plummeted 2 cents to 81 cents US after yesterday’s surprise interest-rate cut, it seems an apt time to address a common misunderstanding about how the falling Canadian dollar affects US equity ETFs denominated in either country’s currency.
This was nicely tackled a year ago by Dan Bortolotti in his Canadian Couch Potato blog here.
Dan — who is both a consulting editor with MoneySense Magazine as well as an investment adviser with PWL Capital — had been chatting with me about the upcoming MoneySense ETF All-Stars feature in general and about the much-misunderstood topic of currency hedging in particular.
Personally, I believe international securities exposure provides diversification both for stocks or bonds but also currencies. I agree with Certified Financial Planner Fred Kirby (see Getting Help section) that the first 20% or 30% of foreign currency exposure doesn’t need to be hedged back into your home country (loonie if you’re Canadian, greenback if you’re American). Of course, American investors who bought US stocks then are laughing. Similarly, if a Canadian invested much of their RRSP directly into US stocks or US equity funds denominated in US$ soon after the 2008 financial crisis and didn’t hedge currencies, they’re probably a happy camper today.
But beyond that, you may want to hedge against excessive currency volatility by using funds that hedge back into your local currency. There is however a view that if your time horizon is longer than five years, you may as well stick with unhedged funds because of the associated costs of hedging.
A common misunderstanding
It’s best to talk to your adviser about the pros and cons of full or partial currency hedging. But realize that even if you have a correct view on the fluctuations between the loonie and greenback, there’s little to be gained by switching between US equity funds denominated either in USD or the CAD. More relevant would be switches between hedged versus unhedged US equity funds. This common misunderstanding was nicely explained in Dan’s now-year-old blog flagged above and republished below.
Dan granted the Hub permission to rerun the blog. Note that because the original version ran in January 2014 ( a year ago), I’ve inserted timing clarifications in square brackets. In the original piece, the loonie was trading below 93 cents US, which was a mere flesh wound compared to the oil-related smashup the loonie has experienced in recent weeks.
That makes the article all the more relevant today! Click through to the original to view some of the graphics that are not reproduced below.
By Dan Bortolotti, Canadian Couch Potato
Special to the Financial Independence Hub
Over the last year [now it’s last two years: JC] the loonie has declined significantly relative to the US dollar: the currencies were at par early last February , but the Canadian dollar closed under $0.92 US on January 10 . That has been a benefit for Canadians who hold US equities: not only did the stocks deliver huge returns in their local currency in 2013, but we got a further boost thanks to the appreciation of the US dollar.
Unfortunately, the drop in our dollar has encouraged some ETF investors to attempt to exploit a buying opportunity. Trying to make currency plays is foolish at the best of times, but it’s especially unwise if you don’t fully understand how currency exposure works.
Meet Gerry, who uses the Vanguard S&P 500 (VOO) to get exposure to US stocks. This ETF is listed on the New York Stock Exchange and trades in US dollars. With the greenback riding high, Gerry plans to sell VOO and use the proceeds to buy an equivalent fund listed on the TSX: the Vanguard S&P 500 (VFV). Gerry tells his friends he’s selling US dollars high and buying Canadian dollars low while keeping his equity exposure the same. If the Canadian dollar eventually gets back to par, he’s going to switch ETFs again and make another tidy profit. Clever, isn’t he?
Not at all. Gerry’s strategy will just incur trading commissions, bid-ask spreads and currency conversion costs—and maybe realize a big capital gain—all while gaining absolutely nothing.
Understanding currency exposure
The problem is Gerry doesn’t understand that these two funds have exactly the same currency exposure. When you invest in foreign equities, your exposure comes from the underlying currency of the holdings, not the trading currency of the ETF. So whether he holds VOO or VFV, Gerry benefits when the Canadian dollar falls, and he suffers when it appreciates.
This idea might be easier to understand if we instead consider a single cross-listed stock, such as Royal Bank of Canada. A Canadian buying Royal Bank on the New York Stock Exchange in USD would not have any exposure to the US dollar, because the holding itself is denominated in CAD:
Imagine the CAD and USD are at par when Gerry buys 1,000 shares of Royal Bank on the TSX for $70 CAD per share. His holding is worth $70,000 CAD.
At the same time, his wife Sharon buys 1,000 shares of Royal Bank on the NYSE, where it is trading at $70 US. Sharon’s holding is valued at $70,000 USD.
Now let’s say the loonie declines to $0.90 USD, but Royal Bank’s stock price remains at $70 CAD. In New York, the stock would now be trading at $63 USD.
If Sharon sold her shares now, she would net $63,000 USD, which is a 10% loss in USD terms. But although Sharon has fewer US dollars than when she bought the stock, each is worth more CAD. And as a Canadian, she likely measures her investment returns in Canadian dollars. In CAD terms, her investment return is zero—just as it is for Gerry.
US stocks mean USD exposure
But as a Canadian investor, Gerry would have benefited from the appreciation in the US dollar, which rose about 6.29% in 2013. When calculated in Canadian dollar terms, his holding in VOO was up 40.65%.
And if Sharon owned VFV, she would have visited Vanguard Canada’s website and found that her holding also returned 40.65% last year:
So if you measure your returns in Canadian dollars, it makes no difference whether you use VOO or VFV. Their holdings—and therefore their exposure to USD—are exactly the same, even though the ETFs trade in different currencies.